Above all else, Business Valuation Models must make common sense!
It is no longer best practice to simply apply a PE Ratio to a going concern's net profit after tax. Careful consideration must be applied to the following factors, which requires the correct application of formulae such as NPV, IRR, MIRR etc under any gearing circumstance.
a) If the business is dependent on foot traffic and positioning, then make sure of your current risks with regard to your lease agreement. This is of paramount importance.
b) Make sure that the expenditure of the business includes a market-related salary for the owner if required to work in the business.
c) How dependent is the business on its owner, and or specialised knowledge?
d) Being a franchisee may be a blessing in good times and a handbrake in bad times, because you are not able to pivot as easily!
e) The lifespan of current or required machinery or income-producing equipment
f) the “Golden Rule” is if the price you are paying for a business cannot comfortable sustain a decent amount of gearing, then it is in all likelihood overpriced.
g) How many percentage points will your IRR and MIRR beat the hurdle rate (funders rate)? This is critical to obtaining finance and viability of the business with or without gearing.
There are many Industry Specific Business Models such as Retail, Manufacturing, Equipment Hire, Financing, Restaurant, Grocery Stores etc. and without exception, all these business types require Cash Flows, with NPV, IRR, MIRR and Exit values.
We suggest that the approach to Business Valuations should be consistent and methodical for all industry types. By this, we mean that when you consider purchasing or creating a market value for the business, your model takes into account cost escalations, the lifespan of equipment requirements, loan or funding amortization and the break-even turnover requirements. It is common cause that an established Pharmacy or Corner Cafe may be far less Volatile than a newly established Restaurant, and these differences will be reflected in a suitable PE Ratio being applied. Some manufacturing types of business may be very capital intensive, but on the other hand, they may have carved out an absolute niche for themselves. There are general and historical guidelines for PE Ratios, but every business and model is unique in its own circumstance when compared to similar business types.
Best Practice Step by Step approach to Business Valuation models!
1) establish the weighted average NPAT for 5 years if available, with a careful eye on the trend
2) establish what equipment needs to be purchased and capitalise this with the useful lifespan approach
3) create your cash flows for up to 10 years with cost and income escalation predictions
4) create Income statements for up to 10 years with taxation with cost and income escalation predictions
5) create your 10-year balance Sheet forecast and see where the owner's equity is heading
6) create exit values at the same PE Ratio at various intervals, and apply CGT if relevant.
7) now perform your NPV, IRR and MIRR. Making sure that IRR and in particular MIRR beats the hurdle rate by as much as possible.
8) Now apply gearing to your model and make sure that the price you are willing to pay will absorb a decent amount of gearing over a 3 to 10-year period.
We have PDF Readers and Explainers on all our model types which are free to download at https://proppro247.com/calculators